Gillard’s budget exposes economy to global headwinds

It’s hard to think about things that can go wrong with the budget on a day when the Australian dollar is falling and US share prices are hitting new records.

But there are dangers, and the budget is based on the fairly sanguine expectation that the terms of trade will settle back to long-term gradual decline that will allow the budget to return safely to surplus with a relatively painless adjustment.

The most obvious source of risk is China, where the economy is making a hazardous transition to a more sustainable growth path. But a more lethal danger lurks in Europe. The euro area is being held together by short-term measures, but the Europeans have yet to find a politically acceptable way for low-productivity southern economies to live under the same currency as the highly productive north.

If they can’t resolve that problem, the euro area almost certainly will break apart, potentially plunging the highly indebted developed economies into a second chapter of the global financial crisis.

Australia’s relatively small public debt gives it the flexibility to deal with a short-lived crisis of the kind most likely to emerge from China.

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But a large, prolonged decline in the terms of trade from another global crisis would be a problem of a much higher order. We would have to adjust to a lower standard of living.

We would need a very different
Tony Abbott
from the one we saw delivering his budget reply on Thursday night.

And, by the way, neither he nor anyone else should count on Japan saving us.

Japan’s aggressive monetary and fiscal stimulus can boost demand and even inflate away a significant part of its huge public debt. But unless the
Shinzo Abe
government can reform the supply side of the Japanese economy, the boost to growth will fade away.

The global downside risks should not be exaggerated. The Reserve Bank of Australia says the risks are about evenly balanced: the world economy is equally likely to be either side of the central forecast. And the most likely scenario is a continuation of the current moderate recovery.

But even a deviation from the central forecast could make a disproportionate difference to country like ours.

Australia, as a small open economy, is vulnerable to problems in our major trading partners. As a commodity exporter, it feels those problems first as a sharp fall in its terms of trade.

The canary in the Australian mine is the federal budget.

The fall in the terms of trade hits national income, which is the source of the government’s tax revenue.

As Deloitte Access Economics says in its Budget Monitor report, “The best proxy for the underlying health of Australia’s federal budget is no longer unemployment – it is now coal and iron ore prices."

Last year a slowdown in China triggered production cuts and an inventory adjustment in the Chinese steel industry which, in turn, saw Australia’s terms of trade drop 14 per cent in 12 months.

There have been only two occasions since 1960 when the terms of trade have fallen harder and, this time, the Australian dollar did not absorb the shock by depreciating with the terms of trade.

Mining profits were hit and so was the government’s company tax revenue.

We should expect more of that kind of volatility. Mining is now a much bigger part of the national economy and mineral and energy prices are very sensitive to changes in demand and supply. Supply is expanding thanks to the global mining investment boom, and even a small weakening of demand is likely to have a noticeable effect on prices.

The rule of thumb is that a 4 per cent fall in the terms of trade wipes about 1 per cent off Australia’s nominal gross domestic product. And, according to the budget papers, a sustained 1 per cent fall in nominal GDP in 2013-14 would add $3 billion to the deficit in that year and almost $6 billion to the deficit in 2014-15.

That is, the deficits would jump from the forecast $18 billion to $21 billion next financial year and from $11 billion to more than $16.5 billion in 2014-15.

Would that be a bad thing? Not if the decline in national income was short lived. The budget is not a profit and loss account. It is supposed to go into deficit in a downturn to cushion the economy.

The problem will be if the terms of trade are on a significantly weaker trend than projected and the government fails to adjust to it properly.

Global demand could be weaker or the supply of iron ore and coal and gas could be stronger, or both if mineral-exporting nations increase output to cushion the impact of weaker prices on their revenues.

If the global recovery is not running smoothly and commodity prices are volatile, a deterioration in the trend could be difficult to recognise.

The Gillard government has given itself little room for error. It has done the minimum, with the budget in structural deficit and projected to get back to surpluses of only about 1 per cent – a level regarded as adequate before the global financial crisis – in the last quarter of the decade.

The government was dealt a poor hand. The slump in nominal GDP growth has been dramatic and tax revenue per dollar of nominal GDP has fallen. Neither was fully predicted by the Treasury.

The level of nominal GDP across the forward estimates in this budget is 4 per cent lower than projected at the time of the 2010-11 budget. But governments are supposed to cope with poor hands.

There is no reason why
Julia Gillard
should have added to the economy’s problems by tightening fiscal policy to push the budget back into surplus in 2012-13 or even 2013-14. As the Treasury says, Australia’s low debt gives us room to adjust more gradually to the weakness in national income, and most economists would say we should use it.

Nor was there any need for Gillard to give up her school reform and national disability insurance initiatives.

But she should have produced a stronger budget that would produce significantly larger surpluses over the medium term. There should have been more long-term savings to offset the rising cost of her reforms and get the projected surpluses up to around 2 per cent of GDP.